Closing the GAAP: New rule expected to be positive for Apple

In the wake of a preliminary rule change for public accounting records, Apple is predicted to benefit with more transparent representation of iPhone and Apple TV sales.

The Financial Accounting Standards Board has drafted a new rule that, if made official, could boost Apple's reported earnings. In a new note to investors, analyst Shaw Wu with Kaufman Bros. said he believes that the change would have a positive impact on traditionally "conservative" iPhone and Apple TV accounting, a practice that has been enforced by the current rules from the FASB. However, Wu said he believes that most professional investors value Apple's stock on its free cash flow, rather than the generally accepted accounting principles (GAAP).

Still, the impact could be noteworthy. Last quarter, Wu estimates that Apple's revenue was underestimated by $1.4 billion, or 17 percent, and earnings per share were under-valued by $0.78, or a whopping 58 percent.

Since the FASB announced its preliminary rule change, after Apple also unveiled its new line of iPods last week, the company's stock has steadily climbed. As of Thursday afternoon, it has traded north of $185. In his report issued Thursday, Wu has maintained a buy rating for AAPL with a price target of $184.

Current GAAP rules required Apple to use "subscription accounting" for iPhone-related filings. Because Apple offers iPhone owners free software updates, it is forced to spread revenue for the iPhone over the term of the contract signed by the wireless customer, typically two years. And Apple has also cited the accounting principles for nominal fees charged to users for upgrades of the iPod touch and Airport Extreme.

In August, Apple petitioned the FASB to change the rules, stating that they make the financial reporting needlessly complex and cloudy for investors. Wu agreed with that assessment, stating that subscription accounting has only served to mask Apple's true financial performance.

"We view this change as positive in that it helps improve the transparency of accounting for both iPhone and Apple TV to more accurately reflect its true value and utility to customers and to AAPL stakeholders," Wu said.

Wu recommends that investors view the Cupertino, Calif., company's free cash flow instead of GAAP reported revenue. He said this is how most professional investors already view Apple's stock, so he does not expect the rule change to have a significant impact on the company's shares.

"But it took a period of time to understand and accept," Wu said. "With this change, (earnings per share) can now also be used, which should make it easier for mainstream investors."

Kaufman Bros. has currently modeled $6.60 earnings per share for Apple in calendar 2010, but believes the company will earn $10 per share on free cash flow.

"Hedge funds and mutual funds are at the heart of this prediction, because they largely set the market’s stock prices. Both use something called a “first call” consensus earnings estimate to decide which names to buy or sell, Cramer said, and it’s “the holy grail of what the big funds are willing to pay up for.” The problem is that, in regards to Apple, the “first call” doesn’t include all of the iPhone sales.

"Once those figures are included, we’ll see a huge boost to the earnings number on which the pros are focused, Cramer said."

Seems like there may be lots of money managers who don't follow the cash flow like Wu thinks.

you want to see the stock hit $200. I predict it will if the new desktop release includes Blu-ray reading optical drives. especially if they can do it without increasing the prices.

all the geek fan boys will rush the stores to buy a new computer. it will be madness

I think if they really wanted to stick it to Microsoft they would find out when those two retail sites are opening and a week before announce that one that date, the new machines will be available for sale at all locations

you want to see the stock hit $200. I predict it will if the new desktop release includes Blu-ray reading optical drives. especially if they can do it without increasing the prices.

all the geek fan boys will rush the stores to buy a new computer. it will be madness

I think if they really wanted to stick it to Microsoft they would find out when those two retail sites are opening and a week before announce that one that date, the new machines will be available for sale at all locations

October 22 would probably be a much better day to announce something like that...

you want to see the stock hit $200. I predict it will if the new desktop release includes Blu-ray reading optical drives. especially if they can do it without increasing the prices.

all the geek fan boys will rush the stores to buy a new computer. it will be madness

Just out of curiosity... where are all the "geek fan boys" getting the money for the computers if they just bought a new iPod and MacBook a few months ago? I want the job that these people have if I can afford such luxuries so often! Where would I apply?

I always find this type of discussion to be ironic. While I understand accounting rules can change reported profits, this doesn't change their business. It doesn't change the number of iphones they're selling. So, if the stock is supposed to represent the cash from the underlying business, this is just semantics.

My kid asked for a new MBP. I used the opportunity to show him about investing. I bought him 100 shares at $140 and he followed it every day. He learned a valuable lesson. The best part, he asked to only sell 10 shares and keep the rest in stock.

Maybe I'll ask him to buy the old man a new tablet when it comes out.

In a world of universal deceit, telling the truth is a revolutionary act.

Calm down. FASB hasn't actually approved this new pronouncement, it still has time for public comment so it might change some and then has to be voted on. I suspect that is why WU hasn't upped his target price if he actually will at all.

Calm down. FASB hasn't actually approved this new pronouncement, it still has time for public comment so it might change some and then has to be voted on. I suspect that is why WU hasn't upped his target price if he actually will at all.

Or, not.

Quote:

Wu recommends that investors view the Cupertino, Calif., company's free cash flow instead of GAAP reported revenue. He said this is how most professional investors already view Apple's stock, so he does not expect the rule change to have a significant impact on the company's shares.

GAAP change does not sell a single extra iPhone or iPod. The profits were hiding in plain sight all along. Any investor/analyst which did not have a handle on this deferred accounting trick (great for cashflow btw, deferred revenue ==> deferred profit ==> deferred taxes) should simply not be in the game. Which is most of those muppets.

What may change is the sentiment as the REAL profits (represented by cash-at-bank, i.e. the 'old school kind') will be more visible.

But there's no news in this - if you hadn't been factoring this into your figures then you were paying a substantial premium for AAPL without undestanding why. Each and every quarter for the next 2 years, AAPL had a not-insubstantial portion of the quarterly profits in the bag (even better, in the bank).

On the negative side, and in the longer term, AAPL will find it hard to continue to screw the poor carriers to continue subsidising iPhone to the degree that they do at the moment which will affect margins.

But, I've seen the best of the rest and, simply put, they are still 2-3 years behind. You could never love a HTC Hero like an iPhone. So many small points and rough edges (software) that all add up to a cumulatively less enjoyable user experience.

Sad to see the great Nokia struggle. They have only one shot left with Maemo/N900 spearheading the effort. If they don't crack it with that then they will be where Motorola is now within 5 years. I still think they're the dark horse in the race (buy Palm perhaps, somebody better before they f'up the opportunity).

My kid asked for a new MBP. I used the opportunity to show him about investing. I bought him 100 shares at $140 and he followed it every day. He learned a valuable lesson. The best part, he asked to only sell 10 shares and keep the rest in stock.

Maybe I'll ask him to buy the old man a new tablet when it comes out.

To complete his education though, he needs a wipe-out. No investor should ever think that the markets move in one direction only. Hope he enjoys his MBP.

Buy him a copy of Ben Graham's venerable "The Intelligent Investor" for his 21st (or 18th if he's really smart) and give him $1000 to prove he's understood the lessons.